Wednesday, May 16, 2012

This chart illustrates the strong tendency of Federal Reserve monetary policy to follow the ups and downs in the economy. Capacity Utilization (blue line) is a proxy for the strength of the economy, and the real Fed funds rate (red line) is a good measure of how tight or loose monetary policy is. The stronger the economy, the more the Fed is prone to tighten monetary policy by increasing the real Fed funds rate, and the weaker the economy, the lower the real funds rate.

Capacity utilization has literally soared in the current recovery, as the manufacturing sector has enjoyed a V-shaped recovery with no end yet in sight, but the Fed continues to keep monetary policy very accommodative. Ordinarily this would be highly disturbing, since it would point to accelerating inflation pressures. But this time around things are very different, given the troubles in Europe which have greatly increased the world's demand for dollar liquidity. The Fed understandably wants to be sure there is no shortage of safe-haven dollars in the banking system to satisfy the world's apparently insatiable demand for them. If the Fed were only concerned about the US economy, they would not be keeping interest rates so low for so long, because the great majority of economic indicators—industrial production and residential construction numbers released today being the two most recent examples—point to continued US economic growth.

The behavior of gold, commodities and the dollar in the past year or so also supports the Fed's decision to keep policy very accommodative. The CRB Spot Commodity index is off 17% from last year's high, and gold has dropped 19% from last September's high, and the dollar is up some 13% from last year's low against other major currencies. All three of these key indicators of monetary conditions are consistent with strong demand for dollar liquidity—and some would even say these moves are symptomatic of a relative shortage of dollars. I'm not prepared to accept that dollars are in short supply, however, since these same charts show that gold and commodity prices are still very high from an historical perspective, and the dollar is still very weak. Instead, I would argue that on the margin there has been an increase in dollar demand relative to supply, but that dollars are still relatively abundant from a broader perspective.

In other words, I don't see any emerging deflationary pressures resulting from the recent weakness in gold and commodities and the strength of the dollar, but rather an easing of inflationary pressures. That is confirmed by the relatively tame readings we saw in yesterday's CPI release, as illustrated in the above chart. So far, so good.

The big thing to watch for is an easing of the tensions in Europe, since this has the potential to dramatically change the world's demand for dollars, and that in turn could result in monetary policy becoming once again inflationary—unless the Fed takes decisive steps to mop up any excess dollar liquidity by either draining reserves or increasing the interest rate it pays on reserves.

UPDATE: I should add the obvious, which is that the first chart suggests that the real Fed funds rate should be approximately 2% by now, if everything else were normal. To get there, given that the core PCE deflator is currently 2% and assuming that the Eurozone situation were to normalize by the end of this year, the Fed would need to raise the funds rate to somewhere in the neighborhood of 4%, and that could be done over the course of a year or two. That would undoubtedly be tough on the T-note and T-bond markets, but not insurmountable, particularly since the steepness of the yield curve implies that some degree of tightening is quite likely. The pain of raising rates is probably exaggerated: For one, a healthier Europe would almost surely be a boost to the US economy, and a stronger economy would boost tax revenues. If spending growth can be held in check, a stronger economy would all by itself bring the deficit down to manageable levels (3-4% of GDP) within a few years. In fact, we're already halfway there: the deficit as a % of GDP is down from a high of 10.4% to the current 7.4%. In other words, as the market loses its desire for Treasuries, the government's need to sell Treasuries would be declining at the same time. The solution to all this is not impossible by any means.

5 comments:

Scott,Interesting charts. Knowing that you believe in trend reversion, does the spike in commodities mean that we will see a reversion to the long term trend line (lower commoditiy price) or do you see commodities @ a fuller higher level than historical prices show (higher prices). In other words, bullish or bearish on commodities? Thanks.

If you look at the dollar exchange rate, the Fed did everything to keep money policy bullish right up until Obama won.

Then it tightened up, and we went into deeper recession, and debt repayments couldn't be made, so the global economy tanked.

The Fed may be apolitical; I hope it is. Why did the dollar exchange rate harden up after Obama won? People had that little confidence in Bush jr. that Obama was a relief?

If the Fed was fighting commodities inflation in 2008-9, that is like trying stop a forest fire by back-burning your own five acre farm. Commodities are global, and there are now larger players than the USA, such as China.

Gold does what it wants, and signifies nothing that I can detect. The largest buyers of gold are now upper-class Chinese and Indians, for family gift-giving. Gold may have a long run at higher levels due to this---US monetary policy? I don't think it figures, when there are 3 billion Chindians buying gold.

Looking at the charts, one could conclude that QE1 and QE2 drove down gold prices. I have to say, this is the weakest connection I can think of. I cannot imagine anyone connects gold to US monetary policy anymore.

Regardless of the past, what is needed for the medium-term future is not only a bullish Fed, but a pro-growth ECB and Bank of Japan.

He who trades economic prosperity for the perceived security of price stability will soon have neither.

We are hitting ourselves in our economic heads with a hammer of tight-monet. We can stop, and embrace growth.

Jeff: that's the real question: how and whether the Fed can tighten policy sufficiently to counteract a big decline in dollar demand. It all depends on how fast the Eurozone situation calms down. Probably not overnight, probably over some extended period. With enough time, the Fed can slowly drain reserves by just not reinvesting coupons or principal repayments. It could simultaneously raise interest rates on reserves by several hundred basis points, I think, without cause any great disturbance; after all, the steep yield curve assumes they will do just that, but of course the uncertainty is over the timing and the speed of rate hikes.

I don't think the size of the federal debt poses any insurmountable problems. Bear in mind that if Europe gets better, the US economy is likely to get stronger, and that will generate stronger tax receipts and slower growth in things like unemployment benefits and food stamps. Increased revenues and flattish spending could go a long way toward reducing the deficit to more normal levels, and we're already half-way there as it is (deficit % of GDP is down from a high of 10.4 to 7.4).